Copyright © 2019 T Leitch

Types of Alt Investments

• Traditional alternative investments
  • Real estate
  • Private equity
  • Commodities
• Modern alternative investments
  • Hedge funds
  • Managed futures
  • Distressed equities

More akin to investment or trading strategies than to distinct asset classes

Common Features of Alternative Investments

• Relative illiquidity, which requires a corresponding return premium
• Improved diversification relative to stocks and bonds
• High due diligence costs due to complex investment structures, specific expertise, and lack of reporting transparency
• Difficulty appraising performance due to complexity of establishing benchmarks

Alternative Asset Due Diligence

Among the questions that must be answered when considering alternative investment managers are:

• Market opportunity – what is it and why is it there?
• Investment process – who is best and why?
• Organization – Are all the pieces in place and stable?
• People – are they trustworthy?
• Terms and structure – are they fair? Are interests aligned properly?
• Service providers – who (auditors, attorneys) supports them?
• Documents – understand the prospectus
• Write-up – formal recommendation

Types of Real Estate Investments

• Direct investment in residences, business real estate and land
• Indirect investment
  • Companies engaged in development, ownership or management (homebuilders, real estate operating companies)
  • Real estate investment trusts (REITs) – public equities representing pooled investments
  • Commingled real estate funds (CREFs) – professionally managed vehicles for substantial pooled accounts
  • Separately managed accounts
  • Infrastructure funds – make private investments in public infrastructure projects (airports, schools, etc)

Real Estate Benchmarks

• National Council of Real Estate Investment Fiduciaries (NCREIF) Property Index for direct investments
  • Value-weighted, quarterly reported
  • Nonlevered return, more representative of private real estate funds
  • Appraisal method leads to stale valuations and appearance of smoother performance
• NAREIT Index for indirect investments
  • Real-time cap weighted
  • Levered, higher standard deviation than NCREIF

Real Estate Investment Characteristics

• Asset with intrinsic value
• Rental income increases stability of returns
• Lack of liquidity
• High transaction costs
• Heterogeneity
• Immobility
• Low information transparency
• Driven by population growth and interest rates
• Mixed results from studies of inflation hedging ability

Types of Private Equity Investments

• Financing private businesses
• Leveraged buyouts of public companies
• Distressed debt investments
• Financing of public infrastructure projects

Supply and Demand for Venture Capital

• Issuers of venture capital include:
  • Formative-stage companies (startups)
  • Expansion stage companies (young, mid-market or pre-IPO
• Suppliers of venture capital include:
  • Angel investors – accredited investors at seed and early stages
  • Venture capital – pooled capital, management support
  • Large companies – strategic partners

Stages of Private Company Financing

• Early-stage financing
  • Seed capital – small amounts to form company and prove idea
  • Start-up – commercialization of product pre-revenue
  • First stage – additional funds if needed (and merited)
• Later-stage financing
  • Financing promising companies needing funds to expand sales
• Exit
  • Merger, acquisition or IPO

Buyout Funds

• Much larger market segment than venture capital
• Mega-cap funds take public companies private
• Mid-market funds purchase private companies or divisions of public companies
• Can add value by restructuring, opportunistically buying below intrinsic value or capturing gains from adding or restructuring debt
• Can realize gains through IPO, sale or dividend recapitalization (borrowing to pay a special dividend)

Use of Convertible Preferred Stock in Venture Capital

• Requires corporation to pay cash equal to multiple of original investment before cash can be paid to common shareholders
• Senior to common stock in liquidation
• Provides incentive to meet return requirements
• Each subsequent financing round is senior to the previous rounds

Structure of Private Equity Funds

Limited partnerships or LLCs

• Expected life of 7-10 years with options for additional 1-5
• Objective is to realize full value by liquidation date
• LP or LLC taxable at shareholder level (no corporate double-taxation)
• No liability beyond initial investment
• Do not usually maintain pools of uninvested capital but receive commitments that they “take down” to make investments or pay expenses
• Manager fee is 1.5-2.5% per annum, plus carried interest
• Carried interest is a share of the profits (usually 20%) retained after limited partners receive a return of capital
• May require hurdle rate
• May have claw-back provision if later investments do poorly

Private Equity Benchmarks

• Events indicating change in market value occur infrequently (financing, IPO, acquisition or failure)
• Cambridge Associates and Thomson Venture Economics provide overall indices for VC and buyout funds
• Typically calculate internal rate of return based on cash flows since inception
• Appraisals are estimates by the venture capitalist, and can be stale
• Often compare firms by vintage year to assure comparability across financing stages and macroeconomic influences

Characteristics of Private Equity Investments

• Illiquid – no secondary market
• Long-term commitments required
• Higher risk relative to public equities
• High expected IRR required (25-30% target)
• Limited information (especially for venture capital funding of novel ideas)

Investments in Commodities

• Direct
  • Cash purchase of physical commodities (agricultural products, metals, oil)
  • Exposure to markets via derivatives (futures)
  • Can require possession, storage, financing, insurance and transportation of commodities
• Indirect
  • Equity in commodity producers

Characteristics of Commodity Investments

• Unusually low correlations to stocks and bonds
• Tend to rise in times of financial and economic distress, lending special diversification benefits at those times
• Determinants of return include:
  • Sensitivity to business cycle
  • Convenience yield (ability to time consumption)
  • Real options (ability of producers to increase or reduce production based on prices)
• Hedge against inflation (particularly for storable commodities such as oil and metals)

Types of Hedge Fund Investments

• Equity market neutral – offsets long positions in stocks with equal short positions to eliminate systematic risk exposure (beta)
• Convertible arbitrage – attempts to exploit anomalies between stock prices and the prices of instruments convertible into stock
• Fixed income arbitrage – predict changes in term structure or credit ratings (typically market-neutral through short positions)
• Distressed securities – Exploit inability or lack of desire of most investors to participate in bankruptcy dealings
• Merger arbitrage – captures price spread between market price and price offered by an acquiror
• Hedged equity – holds long and short positions while remaining net long
• Global macro – exploits major systematic moves in markets through currencies, futures and option contracts
• Emerging markets – focus on less mature investment markets
• Fund of funds – invests in a number of other hedge funds

Hedge Fund Benchmarks

• Generally distinguished by whether report monthly or daily data, are investable or noninvestable, and list actual funds used
• Principle differences include:
  • Selection criteria (track record, assets, etc)
  • Style classification
  • Weighting scheme (equal or asset-based)
  • Rebalancing (how frequent)
  • Investability

Benchmark limitations:

• Most databases are self-reported – are they neutral/accurate?
• Survivorship bias due to poorly performing managers exiting the database
• Stale prices may distort correlation measures
• Backfill bias (managers report missing data at will)

Characteristics of Hedge Funds

• Trading strategy helps explain returns
• Market neutral strategies may better diversify
• Mean-variance optimization sensitive to errors in return estimates, and historical data unreliable
• May contribute undesirably low skewness and high kurtosis

Hedge Fund Due Diligence

• Authenticity of reported performance is doubtful and risk monitoring is difficult
• Due diligence includes learning:
  • Structure (legal entity, manager, domicile, regulatory registrations, personnel, support providers)
  • Strategy (style, instruments, benchmark, niche, holdings)
  • Performance data (all funds since inception)
  • Risk (measurement, controls, use of leverage)
  • Research (changes due to past findings, efforts, budget and personnel)
  • Administration (lawsuits, turnover, disaster recovery)
  • Legal (fee structure, lock-up, subscription amounts, drawback)
  • References (professional, other investors)

Hedge Funds and the Sharpe Ratio

• Sharpe ratio = (annualized return – annualized risk-free rate)/annualized standard deviation
• Increases proportionately with the square root of time
• Not appropriate when investment returns are asymmetrical
• Biased upward by illiquid holdings
• Overestimated when returns are serially correlated
• Does not consider correlations with other portfolio assets
• Has not been found to predict returns
• Can be gamed by lengthening measurement interval, compounding monthly returns but calculating standard deviations before compounding, and writing out-of-money calls and puts, smoothing returns, and using swaps to exclude extreme returns

Types of Managed Futures

• Skill based strategies including:
  • Systematic trading strategies based on rules based models (mostly trend following)
  • Discretionary trading strategies requiring judgment and analysis of markets
• By market focus, commodity managers can be classified as:
  • Financial (financial and currency futures and options)
  • Currency
  • Diversified (financial and physical commodities)

Managed Futures Benchmarks

• Typically comprised of a group of managers with similar style
• Investable benchmarks replicate return to a mechanical, trend-following strategy
• Survivorship bias affects historical data

Types of Distressed Securities

Investment vehicles

• Hedge funds – continued access to capital for managers, greater liquidity for investors
• Private equity funds – fixed term and closed end structure has advantages when investing in illiquid securities

Types of assets

• Publicly traded debt and equity of distressed company
• Newly issued (orphan) equity of company emerging from reorganization
• Bank debt and trade claims
• “Lender of last resort” notes
• Derivatives for hedging related risks

Characteristics of Distressed Security Investments

Market opportunity arises from problems faced by other investors

• Prohibition from holding securities that have fallen below investment grade
• Desire for quick cash in lieu of participation in bankruptcy proceedings
• Failed leveraged buyouts
• Unduly shunned shares of post-restructuring companies

Requires specialist skills

Risk Factors for Distressed Security Investments

• Event risk – unexpected company-specific or situation-specific events that affect valuation
• Market liquidity risk – distressed securities are less liquid and demand is cyclical
• Market risk – economy, interest rates and state of market are relatively less important
• J factor risk – Judge’s track record in adjudicating bankruptcies and restructuring plays a significant role in overall outcome and in which securities perform best

Distressed Security Strategies

• Long-only value investing – investing in perceived undervalued securities in anticipation of a rise in value
• Distressed debt arbitrage – buy distressed bonds and sell distressed equity to earn liquidity preference
• Private equity – gain influence over bankruptcy proceedings as major creditor, influence management decisions and convert position to equity stake